Goldilocks and the 26 Bears
On June 13th, 2022, the S&P 500 Index closed at about 22% below its highs on January 3rd, the first trading day of the new year. Back at the beginning of March, the Nasdaq, driven by public technology companies, fell 20% below its November high. The Dow Jones Industrial Average now sits around 14% under its YTD highs. As of now, two of the three most largely followed indexes have fallen into bear markets. What does this mean?
A bear market is defined when stocks, on average, fall at least 20% off their high. A more qualitative definition is when investors become more risk-averse rather than risk-seeking. Historically, there have been 26 bear markets since 1928, with 27 bull markets during the same time. Typically, causes can vary, generally revolving around a slowing economy, bursting bubbles, or geopolitical crises. In the case of the most recent one, a number of factors have caused stocks to fall. Most obvious to the average American: inflation.
In the past year, a number of things have caused the annual US inflation rate to rise to 8.6% this past May. International Covid-19 lockdowns have boosted prices for goods manufactured overseas. Supply-chain issues have driven down supply, forcing companies to hike their prices. Russia’s war on Ukraine has sent energy prices soaring. Electronics are seeing all-time price highs due to chip shortages. Looking into the number of problems contributing to high inflation in the status quo quickly becomes an endless rabbit hole. What investors have been responding to, however, is the Federal Reserve’s primary response: raising interest rates.
In the latest Fed meeting, chairman Jerome Powell announced a 75 bps rate hike, 50% greater than the originally signaled increase. Additionally, nearly three-quarters of economists expect another 75 bps rate hike to occur next month, raising the Fed fund rate to a range of 2.25-2.50%. While the magnitude of each subsequent rate hike largely relies on current inflation and unemployment data, the Fed is poised to raise rates six more times this year. This impacts the Americans’ wallets and the general economy in various ways, mainly through its effect on banks and credit unions. The Federal fund rate dictates the rate at which banks and credit unions can lend money to each other. As the federal interest rate rises, so do mortgage, car, and credit card payments.
Hedge Your Bets
Now that we’ve established that this bear market sucks for pretty much everyone involved, how do we protect ourselves? We can first look to historical bear markets to gain some perspective on the status quo.
The most recent bear market was in March 2020, when governments shut down nearly all economic activity in response to the Covid-19 pandemic. The DIJA and S&P 500 were down far greater than the 20% required to mark the start of a bear market, but the economic downturn wasn’t prolonged. The S&P 500 only took 126 trading days to swing to a new high, with both indexes returning to a bull. Bear markets, however, are rarely that brief.
Since the 1920s, S&P 500 bear markets have had an average duration of 289 days – or about nine and a half months – with the index falling an average of about 36%. From a different time period, in the 14 bear markets since WWII, the average duration of almost a year, meaning that the current bear market would bottom out around the beginning of 2023. This, of course, is all speculation. Without a crystal ball, there’s no way of seeing when the bear market will end, but it’s still possible to prepare for the worst.
79-year-old Jim Rogers, legendary investor and co-founder of the Quantum Fund and Soros Fund Management, expects:
“this has to be the worst bear market in [his] lifetime, which means it will go down a lot and it will last a long time.”
In this light, Rogers points at two assets: precious metals and agriculture. Precious metals like gold and silver aren’t printable like money, making their prices relatively resilient during a crisis. This, combined with their usage in technology such as solar panels and electric vehicles, makes them highly regarded by investors as good inflation hedges. Rogers likes agriculture for a similar reason. Even in times of high inflation like the status quo, people still need food to eat and clothes to wear. This longevity of agriculture makes it an attractive potential inflation refuge. In addition to inflation hedges, there are a variety of bear market investment strategies that may pose meaningful to experiment with.
In bear markets, while some grieve over losing money in their current portfolio, others drool at the massive “discounts” of share prices. Using a variety of resources, I’ve consolidated a list of ways to be smart while investing in this bear market:
For those seeking to make use of the massive “sale”, dollar-cost averaging is an investment strategy that divides the total amount to be invested across periodic purchases, regardless of the price. This reduces the impact of volatility, allowing you to average your cost down to obtain a better overall buying price. DCA effectively allows one to “buy the way down” so they aren’t tasked with timing the dip.
In terms of overall portfolio management, diversification can help you avoid the adverse effects of putting all your eggs in one basket. Likewise, look for good value companies. During a bear market, everything can be described as undervalued and cheap, so it’s important to decipher if a company is actually a good company. It could also be a good idea to double down on companies you truly believe in because of the lower valuations.
As for specific industries, keep an eye out for defensive stocks with stable revenues regardless of the overall market state. This is the same idea as agriculture; invest in companies that people can’t live without. On the flip side, while I don’t want to insult your intelligence, short selling is a great way to profit from falling prices. Put options and inverse traded ETFs are other choices.
It’s also important to understand that investing money you don’t have is unwise. Bear markets and even minor corrections can prove to be extremely destructive, so investors invest money allocated for life necessities. If it’s brown, lay down. If it’s black fight back. Sometimes, the best thing to do in a bear market is to treat it as a grizzly bear attack – play dead.
Questioning the Recession
I mentioned earlier that the US had undergone 26 bear markets since 1928, 15 of which were accompanied by recessions. Using a different time metric, 9 of 12 recessions after WWII followed bear markets. While bear markets are pretty good indicators of recessions, the two aren’t perfectly correlated. This begs the question: are we already in a recession?
The National Bureau of Economic Research, which typically makes the official call, defines a recession as:
“A significant decline in economic activity that is spread across the economy and lasts more than a few months.”
While the Nasdaq has been in a bear market since March of this year, the S&P just recently dropped below 20% two weeks ago – not quite “months.” A more quantitative definition that is sometimes used to define a recession is two consecutive quarters of real GDP decline. In the first quarter of 2022, US GDP fell 1.5% after increasing 6.9% the quarter before. The end of the week marks the end of the second quarter, so if GDP growth is negative again, the US would meet the GDP definition of a recession. The NBER, however, considers other indicators, including personal income, consumer spending, payroll employment, and industrial production, while waiting to see if the economic downturn is prolonged to at least a few months. While GDP growth is down, it’s important to note the unemployment rate is still fairly low. As of May, the rate stands at 3.6%, which is relatively low compared to historical recessions. The Covid-19 recession saw unemployment rates jump from 3.5% in February 2020 to 14.7% just two months later. Looking even further back at the recession of 2007-2009, unemployment hiked from a 5% starting point in December of 2007 to a peak of 10%. Given low unemployment and the short current lifespan of this bear market, most economists agree that we aren’t in a recession, though the risk of one is high.
Jerome Powell has made it clear that the Fed is currently focusing on bringing inflation down to 2% while maintaining a strong labor market. Achieving this goal through raising interest rates is risky but necessary. During the congressional hearings, Powell said this about a recession:
“it’s not our intended outcome at all, but it’s certainly a possibility.”
The Fed is evidently becoming more aggressive, with the latest 75 bps rate hike becoming the largest rate increase since 1998. This aggressive, “peeling-off-the-bandaid” strategy increases the likelihood of a recession with each subsequent rate jump. While it takes time for the effects to be felt throughout the economy, each rate hike increases the cost of borrowing for both consumers and businesses, weakening economic confidence, job growth, and money supply.
In the general market, as the cost of borrowing increases for companies, the opportunity to expand their businesses stalls, lowering revenues and growth rates. This particularly tends to hurt growth stocks, and more specifically tech stocks, as they’re much more reliant on future cash flow growth. Rate increases also increase the discount rate, eating into the present value of the projected cash flows a lot more.
Other metrics also point toward a recession. On the same day, the S&P fell into a bear market, the yield curve inverted briefly for the first time since April when the spread for the 2-year and 10-year turned negative at -0.02%. Typically longer-term Treasurys return higher yields because of the larger risk profile of the long term. The inversion, however, means that the short-term yield is higher than that of the longer-term, causing the 10-year to 2-year spread to become negative. This points to bond investor expectations for longer-term interest rates to fall, proving to be a reliable recession indicator. For this, we can look at some historical examples.
During the Covid-19 recession, the yield curve inverted in August of 2019. While bond investors certainly couldn’t have predicted the pandemic, the inversion pointed to the possibility of a recession. In the past eight recessions, the 2- and 10-year yield spread inverted before 7 of them. The 3- and 10-year spread, however, had a perfect track record. This doesn’t mean that the yield curve inversion acts like a magical predictor of the future, though. When the yield curve is stripped of record-high inflation rates, the “real yield” curve hasn’t inverted and maintains its upward slope. Some predict that the inversion means that global investors believe that the Fed will succeed in driving down inflation with rate hikes and make minor rate cuts in the longer term, achieving a “soft landing”.
Cryptomadness
Like a toxic ex, “this time, things will be different.” One last thing to add to the unique situation of this economy is the recent explosion in the popularity of cryptocurrencies. Let’s take a look at Bitcoin as a preface. Prior to the last recession, BTC’s market capitalization hovered around the $160 billion mark. Since then, it’s gone on an insane bull run, peaking at around $1.2 trillion. This growth, however, has come to a screeching halt. On June 13th, the same day the S&P fell into a bear market and the yield curve inverted, crypto had one of its worst days ever. The market cap of crypto that once peaked at $3 trillion in November 2021 fell under $1 trillion, BlockFi cut 20% of their staff, and crypto lender Celsius halted all withdrawals.
The overall crypto market plunge can be accredited to a few main causes. First was the crash of LUNA coin and TerraUSD around mid-May. TerraUSD was a stablecoin pegged to the US dollar, aimed at maintaining price stability through algorithms. LUNA was the sister cryptocurrency to TerraUSD and was used as a token for volatility absorption, governance, transaction fees, and mining rewards. Today, TerraUSD, which is supposed to follow the US dollar, has lost 99.9% of its value, and LUNA sits far below one cent. The cause of the crash flows back to the mint/burn mechanism of UST, aimed at maintaining supply and demand, where minting a dollar worth of UST requires burning a dollar worth of LUNA, and vice versa. The algorithm, however, failed when market volatility and an overall downward crypto trend led to a negative feedback loop, where the fallen value of UST contributed to a diminished demand for LUNA. Those invested lost virtually all their money, with many losing large proportions of their life savings.
Before the dust settled on the LUNA-Terra crash, another crisis shook crypto markets. Celsius, a multi-billion-dollar crypto lending and staking platform, stopped all withdrawals from the platform on June 12th. Lending and Staking involve leasing one’s crypto to the blockchain or traders to earn interest on their owned crypto assets passively. Celsius leases on the investor’s behalf and keeps returns above its promised rate. Celsius was unable to raise money for users to withdraw their funds because of a sharp drop in stETH – a staking token Celsius had made a large investment in. After they froze all transactions on their platform, an enormous sell-off occurred where all cryptos plunged.
The huge crypto nosedive provides some insight into the future. As a sector, crypto currently isn’t large enough to cause an economic recession on its own, but the recent fall draws some parallels to the 2008 housing crisis. Many economists compare crypto investors to those who took out subprime mortgages, as 44% of crypto investors are non-white, and 55% don’t have a college degree – the same groups of people targeted for subprime mortgages. The housing market back then was around $6.5 trillion, far greater than crypto’s peak at $3 trillion, but if the sector continues to grow in popularity, its fluctuations could have an impact on the greater economy. The current crypto crash, while not the cause, could very well influence the probability of a recession in the next year as people continue to lose money in cryptocurrency.
great read!
great read, keep it up. i subscribed 🤙🏾